How IRA and Roth IRA distributions are taxed

Distributions from a traditional IRA generally are taxed under IRC Section 72 (relating to the taxation of annuities).

Under these rules, a portion of the distribution may be excludable from income.

The amount excludable from the taxpayer’s income for a year is that portion of the distribution that bears the same ratio to the amount received as the taxpayer’s investment in the contract (i.e., nondeductible contributions) bears to the expected return under the contract.

In no case will the total amount excluded exceed the unrecovered investment in the contract.

All traditional IRAs are treated as one contract, all distributions during the year are treated as one distribution, and the value of the contract, income on the contract, and investment in the contract are computed as of the close of the calendar year with or within which the taxable year begins.

The total IRA account balance is the balance in all traditional IRAs owned by the taxpayer, as of December 31 of the year of the distribution.

To this amount is added the amount of any distributions made (i.e., the amounts for which the nontaxable portion is being computed) and any outstanding rollover amounts (i.e., any amount distributed by a traditional IRA within sixty days of the end of the year, which has not yet been rolled over into another plan, but which is rolled over in the following year).

If it is not rolled over, the amount is not treated as an outstanding rollover.

Thus, the nontaxable portion of a distribution (whether from a traditional individual retirement annuity or account) is equal to the following:

Unrecovered Nondeductible

Contributions

x Distribution Amount

Total IRA Account Balance +

Distribution amount +

Outstanding Rollovers

Nondeductible contributions will not be excluded from gross income as investment in the contract where the taxpayer is unable to document the nontaxable basis through the filing of Form 8606, Nondeductible IRAs (Contributions, Distributions and Basis) for the year in which such nondeductible contributions were made and the year in which they were distributed.

An individual may recognize a loss on a traditional IRA, but only when all amounts have been distributed from all traditional IRAs and the total distributed is less than the individual’s unrecovered basis. The deduction for the loss is a miscellaneous itemized deduction.

Despite the pro-rata rule applicable generally to distributions from a traditional IRA, distributions after 2001 that are rolled over to a qualified plan, an IRC Section 403(b) tax sheltered annuity, or an eligible IRC Section 457 governmental plan are treated as coming first from all non-after-tax contributions and earnings in all of the IRAs of the owner.

Because after-tax contributions cannot be rolled over to eligible retirement plans other than another IRA, this ordering rule effectively allows the owner to rollover the maximum amount permitted. Appropriate adjustments must be made in applying IRC Section 72 to other IRA distributions in the same taxable year and subsequent years.

How are amounts distributed from a Roth IRA taxed?

Where a Roth IRA contains both contributions and conversion amounts, there are ordering rules that apply in determining which amounts are withdrawn. In applying the ordering rules, traditional IRAs are not aggregated with Roth IRAs. All Roth IRAs are aggregated with each other.

Regular Roth IRA contributions are deemed to be withdrawn first, then converted amounts second (in order if there has been more than one conversion). Withdrawals of converted amounts are treated first as coming from converted amounts that were includable in income. The ordering rules continue to treat earnings as being withdrawn after contributions.

“Qualified distributions” from a Roth IRA are not includable in gross income. Thus, earnings are tax-free, not tax deferred as with traditional IRAs.

A “qualified distribution” is any distribution made after the five-taxable year period beginning with the first taxable year for which the individual made a contribution to a Roth IRA (or such individual’s spouse made a contribution to a Roth IRA) established for such individual and such distribution meets one of the following requirements:

(1) It is made on or after the date on which the individual attains age 59½;

(2) It is made to a beneficiary (or to the estate of the individual) on or after the death of the individual;

(3) It is attributable to the individual’s being disabled.

(4) It is a “qualified first-time homebuyer distribution” (see below).

A “qualified first-time homebuyer distribution” is any payment or distribution that is used within 120 days after the day it was received by the individual to pay the qualified acquisition costs of a principal residence of a first-time homebuyer.

The aggregate amount of payments or distributions received by an individual from all Roth and traditional IRAs that may be treated as qualified first-time homebuyer distributions is limited to a lifetime maximum of $10,000.

The first-time homebuyer may be the individual, his or her spouse, any child, grandchild, or ancestor of the individual or his or her spouse.

A first-time homebuyer is further defined as an individual (and, if married, such individual’s spouse) who has had no present ownership interest in a principal residence during the two year period ending on the date of acquisition of the residence for which the distribution is being made.

In calculating the five-taxable-year period, it is important to remember that contributions to Roth IRAs, as with traditional IRAs, may be made as late as the due date for filing the individual’s tax return for the year (without extensions).

Thus, if a contribution is made to a Roth IRA between January 1, 2014 and April 17, 2014 for the 2013 taxable year, the five-taxable-year holding period begins to run in 2013.

For purposes of determining whether a distribution from a Roth IRA that is allocable to a “qualified rollover contribution” from a traditional IRA is a “qualified distribution,” the five-taxable-year period begins with the taxable year for which the conversion applies. A subsequent conversion will not start the running of a new five-taxable-year period.

The five-taxable-year period for determining a “qualified distribution” is not recalculated on the death of the Roth IRA owner; the five-taxable-year period of the beneficiary includes the period the Roth IRA was held by the decedent.

Any nonqualified distribution will be includable in income, but only to the extent that the distribution, along with all previous distributions from the Roth IRA, exceeds the aggregate amount of contributions to the Roth IRA. For this purpose, all Roth IRAs are aggregated. To the extent such distributions are taxable; the 10 percent early distribution penalty may apply.

Distributions allocable to “qualified rollover contributions” will be subject to the early distribution penalty regardless of whether the distribution is taxable if the distribution is made within the five-year period beginning with the tax year in which the contribution was made. Distributions of excess contributions and earnings on these contributions are not qualified distributions.

An individual may recognize a loss on a Roth IRA, but only when all amounts have been distributed from all Roth IRAs and the total distributed is less than the individual’s unrecovered Roth IRA contributions. The deduction for the loss is a miscellaneous itemized deduction.

A transfer of a Roth IRA by gift would constitute an assignment of the Roth IRA, with the effect that the assets of the Roth IRA would be deemed to be distributed to the Roth IRA owner and, accordingly, treated as no longer held in a Roth IRA.

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